The consequence of devaluation  

By Fernando Fajardo |August 07,2019 - 06:52 AM

A couple of days ago, China allowed its currency, the yuan, to fall or to devalue against the US dollar beyond the 7 yuan to a dollar mark from around 6.9 weeks before. The Yuan reached its highest point at 8.73 to a dollar in 1994 and lowest at 1.53 to a dollar in 1981.

The recent devaluation of the yuan came after the US Treasury accused China of deliberately influencing the exchange rate to gain an unfair competitive advantage in international trade.

Before that last week, Trump tweeted that starting September he would impose a 10 percent tariff on the remaining imports from China not previously covered by the 25 percent tariff that he ordered months ago.

Both action and reaction resulted in the drastic fall of the global stocks towards the end of last week and in the last two days because of their unsettling impact on the financial market.

Theoretically, the purpose of devaluation is to makes one’s export cheaper to foreign buyers, thus increasing its exports. At the same time, it makes its imports expensive, thus reducing its imports. As a result, the country that devalues its currency will experience an increase in its trade surplus or a decrease in its trade deficit and thus boasting its GDP.

This is not always the case though. It also depends on which has moved fasterthe fall in the export price because of devaluation or the rise in quantity exported because of the falling export price. If the fall in export price is proportionately greater than the rise in quantity exported (when the products in question have inelastic demand),then less will be earned by the exporting country that devalues its currency.

In the 1980s, the US suffered from a huge trade deficit with Japan and Germany. In the case of Japan, Reagan thought that it was because the Japanese were intentionally keeping the Yen low against the U.S. dollar. He demanded Japan to raise the Yen against the dollar or devalue the dollar against the Yen. Thus, starting from over Y250 to a dollar before 1985, the exchange rate move to round Y150 to a dollar in 1986 and finally to less than Y125 to a dollar in 1987.

Yet the result was not a happy one to the Americans. The dollar was cut down to half but the trade deficit had doubled. What was wrong?

It was not that the Japanese were not willing to buy more goods from the US after the devaluation of the U.S. dollar. What was wrong was that devaluation alone was not enough to correct the trade deficit. In the case of the Americans, to export more they needed not just a lower dollar exchange rate but also having the readiness and willingness to produce more for export in the desired quantity, quality, and price and the ability to penetrate the market outside that have a very different structure than in their own country.

These things the Americans did not do. They were mainly contented with increasing their domestic price and profit more when because of devaluation the imported goods from Japan became expensive to the Americans buyers, as Daniel Burstein mentioned in his 1988 book, Yen.

Burstein also said that devaluing the dollar could have been a powerful tool in promoting U.S. trade competitiveness if it were linked to government support for export industries, credits for trade financing, tax incentives for restructuring domestic industry, and a control mechanism to prevent business from squandering the currency advantage on price hikes. He added that those ideas stood in contradiction to the Reagan’s administration’s basic article of faith; let the free market decide.

One thing more about devaluation is that when a country devalues its currency, it also diminishes the value of its capital and its asset.

In the case of the halving of the U.S. dollar in the mid 1980s, it also made the Japanese doubly richer and thus making it cheaper for them to buy or invest in American assets from Hawaii to the east coast and to the west coast of the U.S. to the great consternation of the Americans. It also allowed the Japanese to put up new factories inside the US that directly competed with US manufacturers right in their own neighborhood without the hassle of producing and shipping them from Japan.

How the current trade war will fan out between the US and China or whether China will continue to allow the Yuan to fall against the U.S. dollar, no one is sure. However, if the Americans and the Chinese were to read the history of devaluation in the past, they should know what to do or not do to avoid catastrophic results. 

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